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Mean-reversion vs. adjustment to PPP: the two regimes of exchange rate dynamics under the EMS, 1979-1998

  • Bessec, Marie

This paper examines jointly the empirical relevance of the mean-reversion and the PPP hypotheses in the exchange rate dynamics under the EMS. Given the non-stationarity and the non-linearities characterizing the foreign exchange rate dynamics, this question is studied using a MS-ECM model: it allows a discontinuous adjustment towards the cointegration relationship. We find that the European exchange rates of the ERM members display mean-reversion towards the central parity in the credible regime, whereas they adjust to the PPP during the volatile period. The first mechanism is due to the stabilizing effect of a credible target-zone, while the second one can be explained by the realignments made in accordance with the underlying inflation rates.

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Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 20 (2003)
Issue (Month): 1 (January)
Pages: 141-164

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Handle: RePEc:eee:ecmode:v:20:y:2003:i:1:p:141-164
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